The International Monetary Fund just blew a big hole through trickle-down economics.
You’ve probably heard of trickle-down economics: It gained popularity in the 1970s and was a major part of the pro-business “Reaganomics” agenda of the 1980s.
The theory is simple enough: If you concentrate capital (money) at the top of the economic ladder (among the wealthy and corporations), that money will be more productive than it would be elsewhere, and it will create work and therefore income for everyone else.
Whether it was sound or not, it was a compelling theory for many in the business and political world, because it meant, among other things, tax cuts for top earners. And it was used for years as part of the foundation for successive corporate tax cuts around the world.
But now the IMF is raising one little problem with the theory: Apparently it doesn’t work. That’s the argument in the fund’s new research paper, “Causes and Consequences of Income Inequality.”
Looking at data from 159 countries from 1980 to 2012, researchers found that when the wealthiest 20 per cent see their share of income rise by one per cent, the economy grows 0.08 percentage points slower over the next five years.
“In contrast, an increase in the income share of the bottom 20 percent (the poor) is associated with higher GDP growth,” the report says. When the poorest 20 per cent increase their share of total income by one per cent, the economy grows 0.38 percentage points faster.
Translation: Give tax breaks or higher wages to the poor, and the economy will grow. Give tax breaks or higher incomes to the rich, and you reduce economic growth.
“The benefits do not trickle down,” the researchers conclude.
The report offers a number of possible explanations for why greater inequality means lower growth:
— Greater inequality can lead to “underinvestment in education as poor children end up in lower-quality schools and are less able to go on to college.” A less educated population means a less productive population.
— Greater inequality “dampens investment, and hence growth, by fueling economic, financial, and political instability,” the report says. “Studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards.”
— Greater inequality “can lead to policies that hurt growth.” A stronger economic elite can result in less generous government benefits, which disproportionately impacts the poor. And a backlash against that can “fuel protectionist pressures against globalization and market-oriented reforms,” the research paper argues.
The paper puts forward some suggestions on how to tackle growing inequality, which it calls “the defining challenge of our time.” Developed economies should focus on “making tax systems more progressive,” and focusing on education and other forms of development of “human capital and skills.”
“Irrespective of the level of economic development, better access to education and health care and well-targeted social policies, while ensuring that labor market institutions do not excessively penalize the poor, can help raise the income share for the poor and the middle class,” the report concludes.
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